Mike Grenby and his wife bought their first house in Vancouver in 1971. They worked hard and sacrificed (their son didn’t make it to Disneyland until he was 21) — and they paid off their mortgage in seven years.

When the couple went to buy their second, slightly larger home, they did not want to have debt again.

“We had enough savings that if we cashed in the RRSP, we wouldn’t have to take out another mortgage,” he said. “Having worked so hard to pay off the first one, we thought it was worth the good feelings to cash the RRSP, pay off the mortgage and not have to start all over again paying off debt.”

Tim Fraser for Postmedia News

Taking money from your retirement fund to avoid or pay debt — would this make sense for you?

Overall consumer debt, including mortgages, continues to grow. In the third quarter, Canadians owed $1.36-trillion, up from $1.3-trillion a year earlier, according to the credit monitoring firm Equifax Canada. The average Canadian consumer debt is expected to rise 4% in 2014. Given our increasing debt levels and this low yield environment, financial experts say it might make sense for some people to use available funds to pay off debt.

You could do it — you could also spend all of your savings on a year’s supply of fine cheeses — but that doesn’t mean that you should.

“The tax hit on cashing in RRSPs is really big,” says Perry Quinton of Investor Education Fund. “If you’re taking money out of your RRSP before you retire, you’re immediately going to pay a withholding tax. If you take up to $5,000, you’re going to pay 10%. If it’s between $5,000 and $15,000, they hold back 20% and if it’s more than $15,000, they hold back 30%.”

That means, if you need $8,000 to pay off your credit card, you’ll have to withdraw $10,000.

You also have to report that money as taxable income and you may have to pay even more at tax time, she adds.

The other downside is that you lose the RRSP contribution room so you can’t re-contribute the money that you take out of the account.

“All of a sudden you’re taking out of your retirement fund and you can’t re-contribute to that. On top of that, you lose all of the opportunity of the growth for that money when it was sitting there,” says Jeff Schwartz, president of Consolidated Credit Counseling Services of Canada.

“If you take $6,000 out of your RRSP and you’re earning 7% every year after 20 years, you’ve lost more than [$23,000] of RRSP money. So it is a big deal.”

Mr. Grenby did not make his decision lightly. But he did this in the late ‘70s when different tax rules were in place and interest rates were reaching double digits and rising.

However, knowing what he knows now, he would not have taken the $60,000 to $70,000 out of his RRSP.

[np_storybar title=”Crunching the numbers” link=””]

What if I withdrew money from my RRSP to get rid of a $20,000 debt? Wealth advisor Gary Gorr provided us with some hypothetical numbers:

If you withdraw up to $5,000, the government withholds 10% of it. From $5,001 to $15,000, it’s 20% and then 30% for anything greater than $15,000.

So let’s assume that you’re paying a minimum of 3% to carry your $20,000 of debt or $600 a month. The debt has an interest rate of 18%.

To pay off your debt, you must withdraw $25,000 from your RRSP (the withholding rate is 20%). Now, you’ve freed up $600 every month now that the debt is eliminated.

But what would the $25,000 be worth at age 65 at a 6% yield if it had not been withdrawn?

If you were 35 when you did this, that $25,000 in the RRSP would be worth $143,587 when you were 65.

Ouch. Okay, what if I withdraw the money, pay off the debt, and invest the $600 a month every month to age 65?

If you indeed did do this, your deposits would be worth $569,219, provided you have the discipline to save the $600 a month, Mr. Gorr says.

Well, what if I could budget and reduce spending and find an extra $300 per month on top of the minimum $600 to get rid of the debt?

In 27 months, you would be debt free, your RRSP would be intact, and now you can save even more toward your future, he says. [/np_storybar]

“If I had not cashed in the RRSP, the RRSP would’ve grown tax free to far more than what we saved by paying the mortgage off quickly,” says the financial columnist who teaches journalism and public speaking at Australia’s Bond University.

Gary Gorr, a Belleville-based wealth advisor, cautions people against this last resort but points out that some cases have more benefit than others.

“If, for example, you’re going on parental leave, you’re going to have lower income, that would be a year where you could take money out of your RRSP and pay off high-interest debt because it’s going to get taxed at a lower rate than when you’re working full-time,” Mr. Gorr says.

“Let’s say you’re earning less than $40,000 a year but you’ve got money in your RRSP. Let’s say that you’re relatively new in the workforce. Putting money into your RRSP isn’t giving you a really big tax deduction. I could see taking money out of your RRSP to pay your student loan debt.”

Canadians raid their RRSPs for a number of reasons — not just out of desperation, from fear of declaring bankruptcy or under threat of Canada Revenue Agency.

A CIBC report found that 1.9 million Canadians withdrew $9.3-billion from their RRSPs in 2008 and 80% of the withdrawals were made by individuals under 60.

A Scotiabank poll found that among Canadians who hold an RRSP, 40% have withdrawn funds from it.

They do it to buy a home, perhaps through the Homebuyers’ Plan (16%), or to go to school, perhaps through the Lifelong Learning Plan. A Scotiabank poll found that the second-most popular reason to withdraw from an RRSP was to pay off debt (8%).

Before you resort to withdrawing from your RRSP, look for alternatives.

Are there other long-term investment vehicles that may not be so costly to take money out? Maybe a TFSA where the money comes out tax-free and you get the contribution room back the following year?

Are your debts out of control? Can you consolidate them into one low-interest loan? Can you negotiate with your creditors to decrease how much you owe? Can you borrow from friends and family?

Another strategy would be to contribute to your RRSP and use the refund to pay down your debt.

“An individual who is in panic mode over debt…[where] every single night, they go to bed and they’re in a sweat. You can make a good argument for that person to get rid of the emotional stress in their life by paying off some debt or all of it using RRSP assets,” says Andrew Pyle, a senor wealth advisor with ScotiaMcLeod. “If someone were to go into their RRSPs, grab $20,000 and pay off a Visa card, it’s like a euphoria; but I think discipline can quickly be lost by these lump sum debt pay downs. The risk is, if they do it all in one shot and pay down a lot of debt, they may go right back to their old habits the next day.”

Experts say that it is important for you to understand why you are resorting to this measure and to institute a financial plan.

“The problem is that people keep spending. The reason we’ve gotten to where we are today is because credit is so accessible and we live in a culture of instant gratification,” Ms. Quinton says. “If you clear your debts and keep spending, it doesn’t work. You’ve got to change your lifestyle.”

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